article review 5

  

After reading the article, draft a two-page paper by explaining what you learned about accounting and finance. You can
include any reflections related to the article; however, address in paragraph form at least the following in your two-page
paper:
 What specific actions (or lack of) led to Enron’s bankruptcy?
 What types of fundamental accounting and auditing practices eventually contributed to the fraud performed by
Enron?
 Briefly describe the ethical environment that led to the fraud.
 How did Enron’s bankruptcy impact the financial markets for Enron’s competitors?
 Briefly describe what you learned about the importance of the auditing process. The purpose of this assignment is for you to explore the critical practices of accounting and finance within the industry,
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The current issue and full text archive of this journal is available at
www.emeraldinsight.com/0307-4358.htm
MF
38,7
Andersen implosion over Enron:
an analysis of the contagion effect
on Fortune 500 firms
678
Joann Noe Cross
Department of Accounting, University of Wisconsin Oshkosh,
Oshkosh, Wisconsin, USA, and
Robert A. Kunkel
Department of Finance & Business Law, University of Wisconsin Oshkosh,
Oshkosh, Wisconsin, USA
Abstract
Purpose – The purpose of this paper is to examine how the Andersen implosion over Enron
impacted Fortune 500 firms that were competitors of Enron and/or audited by Andersen. This event
provides an opportunity to study various contagion effects.
Design/methodology/approach – An event study methodology is used to analyze the immediate
financial impact of the Andersen implosion on competitors of Enron and/or firms audited by
Andersen. More specifically, how did the announcement of the implosion impact these firms?
Findings – The results support a strong industry contagion effect where Enron’s failure benefited
the surviving energy/utility firms who could then increase their market shares. The authors find the
energy/utility firms not audited by Andersen, on average, experienced an astounding 2.5 percent
increase in market capitalization when the audit scandal was announced. In dollar terms, the mean and
median market capitalization increases were $226 million and $101 million, respectively. In the
aggregate, the 21 utility/energy firms gained $4.76 billion in market capitalization.
Research limitations/implications – The results show the importance of the auditing process and
the impact of unethical actions on the firm, their auditor, and their competitors. One limitation is the
data are limited to large Fortune 500 firms.
Originality/value – This is the first study, to the authors’ knowledge, that evaluates the contagion
effect of the Andersen/Enron audit scandal on Fortune 500 firms: in the same industry as Enron;
audited by Andersen; and operating in the same industry as Enron and audited by Andersen.
Keywords United States of America, Financial reporting, Auditing, Energy industry, Banruptcy,
Andersen, Enron, Contagion effect, Fortune 500, Event study
Paper type Research paper
1. Introduction
The whole duty of an auditor may be summed up in a very few words – it is that of verifying
balance sheets (Accountant, editorial, April 23, 1881 as quoted in Chambers (1995, p. 81)).
Managerial Finance
Vol. 38 No. 7, 2012
pp. 678-688
q Emerald Group Publishing Limited
0307-4358
DOI 10.1108/03074351211233131
[A]uditing, as carried on under the present system, is of no practical concern as evidence of
the true financial position of a company [. . .] auditors’ certificates [. . .] merely certify that the
balance sheet is correctly copied from the books, sometimes with the addition that the
auditors have counted the cash and inspected the bill case and the security box. Audits under
such conditions are a delusion and a snare (Vanity Fair, October 6, 1883 as quoted in
Chambers (1995, p. 94)).
Fundamentally, an audit is viewed as a process of obtaining evidence that the
statements made by management about the financial facts of their business are true.
Indeed, as early as 1895, Worthington, in a description of the new field of professional
accounting, writes that the manager who (Parker, 1986):
[. . .] fails to adopt this wise precaution against fraud and embezzlement is frequently running
as great a risk as he would do in failing to insure his stock against the ravages of fire (Parker 31).
What then do auditors do? Auditors gather evidence to support the assumption that
financial statements “fairly” (a different assumption than “accurately”) reflect the
activities and current status of the firm. The evidence can be collected by various activities
such as examining source documents, observing the counting of inventory, talking to
members of management and other staff, and obtaining confirmation of transactions from
outside the organization. In most cases, the audit also involves making sure those policies
within a firm designed to insure proper reporting of its activities are in place and being
followed.
The confusion that arises is in the definition of “true picture”. In essence there are
alternative definitions of “true” varying from fairness (which is what auditors believe)
to accuracy (which auditors do not claim, but which investors assume). When the
management of a Securities Exchange Commission regulated firm issues a report that
is believed to be other than a true picture of that firm, investors leap to sue whomever
they can to limit their potential losses. It is, then, within the courts that the difference
between fair and accurate becomes debated and decided as in the case of the public
accounting firm Andersen.
Our study analyzes the contagion effect of the Andersen implosion over Enron on
Fortune 500 firms:
.
operating in the same industry as Enron – an industry contagion effect;
.
audited by Andersen – an auditor contagion effect; and
.
operating in the same industry as Enron and audited by Andersen – an
industry/auditor contagion effect.
Regarding the industry contagion effect, did the market view the implosion as negative
whereas Enron competitors may have undertaken similar operations, or as positive in
that Enron’s likely bankruptcy would enable competitors to gain market share?
Regarding the auditor contagion effect, did the market view the implosion as negative in
that other Andersen audited firms may have audit problems similar to Enron’s?
Regarding the industry/auditor contagion effect, did the market view the implosion as
negative whereas Enron competitors audited by Andersen may have not only
undertaken operations similar to those of Enron, but also have audit problems similar to
Enron’s?
2. Background
2.1 Literature review
Aharony and Swary (1983) in their seminal paper examined the contagion effects of
three prominent bank failures on the banking industry using an event study model.
Two of the three banks suffered from activities specific to the bank. For example, one
bank failure was due to fraud and internal irregularities while the other bank failure
was due to illegal channeling of loans from a subsidiary to the bank which was an
Andersen
implosion
over Enron
679
Fundamentally, an audit is viewed as a process of obtaining evidence that the
statements made by management about the financial facts of their business are true.
Indeed, as early as 1895, Worthington, in a description of the new field of professional
accounting, writes that the manager who (Parker, 1986):
[. . .] fails to adopt this wise precaution against fraud and embezzlement is frequently running
as great a risk as he would do in failing to insure his stock against the ravages of fire (Parker 31).
What then do auditors do? Auditors gather evidence to support the assumption that
financial statements “fairly” (a different assumption than “accurately”) reflect the
activities and current status of the firm. The evidence can be collected by various activities
such as examining source documents, observing the counting of inventory, talking to
members of management and other staff, and obtaining confirmation of transactions from
outside the organization. In most cases, the audit also involves making sure those policies
within a firm designed to insure proper reporting of its activities are in place and being
followed.
The confusion that arises is in the definition of “true picture”. In essence there are
alternative definitions of “true” varying from fairness (which is what auditors believe)
to accuracy (which auditors do not claim, but which investors assume). When the
management of a Securities Exchange Commission regulated firm issues a report that
is believed to be other than a true picture of that firm, investors leap to sue whomever
they can to limit their potential losses. It is, then, within the courts that the difference
between fair and accurate becomes debated and decided as in the case of the public
accounting firm Andersen.
Our study analyzes the contagion effect of the Andersen implosion over Enron on
Fortune 500 firms:
.
operating in the same industry as Enron – an industry contagion effect;
.
audited by Andersen – an auditor contagion effect; and
.
operating in the same industry as Enron and audited by Andersen – an
industry/auditor contagion effect.
Regarding the industry contagion effect, did the market view the implosion as negative
whereas Enron competitors may have undertaken similar operations, or as positive in
that Enron’s likely bankruptcy would enable competitors to gain market share?
Regarding the auditor contagion effect, did the market view the implosion as negative in
that other Andersen audited firms may have audit problems similar to Enron’s?
Regarding the industry/auditor contagion effect, did the market view the implosion as
negative whereas Enron competitors audited by Andersen may have not only
undertaken operations similar to those of Enron, but also have audit problems similar to
Enron’s?
2. Background
2.1 Literature review
Aharony and Swary (1983) in their seminal paper examined the contagion effects of
three prominent bank failures on the banking industry using an event study model.
Two of the three banks suffered from activities specific to the bank. For example, one
bank failure was due to fraud and internal irregularities while the other bank failure
was due to illegal channeling of loans from a subsidiary to the bank which was an
Andersen
implosion
over Enron
679
MF
38,7
680
activity specific to the bank. They concluded that if the bankruptcy was due to events
specific to the affected bank, then there was no contagion effect. However, if the events
were associated with problems that were correlated across all banks in the industry,
then a negative contagion effect could be expected. In this case the bank failure was
due to large losses related to risky foreign exchange transactions. Since many banks
also engaged in risky foreign exchange transactions, the market assumed those banks
may likely suffer large losses.
Lang and Stulz (1992) study a sample of 59 bankruptcies in 41 industries and found
that bankruptcy announcements could have both a positive and a negative effect
on competitors’ equity. They found that bankruptcies have moderate contagion effect on
competitors in the same industry. Furthermore, the impact increases with stronger
competition, higher industry leverage, and similarity of cash flow characteristics
between the failed firm and competitors. In general, they found a negative contagion
effect with a 2.87 percent decline in market capitalization in highly leveraged industries,
while the impact for low leveraged industries was slightly positive. Competitors with
high leverage and a high degree of competition had a 3.2 percent decline in market
capitalization as a response to bankruptcy in their industry. They also found a
significant competitive effect where both leverage and the degree of competition are low.
Fenn and Cole (1994) studied the contagion effect associated with announcements of
asset write-downs by two life insurance companies in 1990 by examining the impact on
54 competing insurance companies. They found evidence of a significant contagion
effect for companies with an asset composition similar to that of the announcing firm.
The results also supported the hypothesis that investors are relatively uninformed
regarding the asset composition of life insurance companies due to high monitoring
costs, but that an announcement of asset restructuring leads the market to reevaluate
the asset composition of all insurance companies.
Cheng and McDonald (1996) studied seven airline and five railroad industry
bankruptcy announcements between 1962 and 1991. They found a competitive effect
in the airline industry with an abnormal return of 2.80 percent and a contagion effect in
the railroad industry with an abnormal return of 2 0.59 percent. These results conclude
the industry’s market structure will determine the bankruptcy announcement’s impact
on the stock prices of the surviving firms. For example, the positive competitive effects
in the airline industry can be attributed the failure of one firm gives more market
power to the competitors.
Polonchek and Miller (1999) examined the effect of 69 equity offerings by insurance
companies between 1977 and 1993. They conclude that equity offerings are market
indicators of management belief that the company’s stock is overvalued. As such, the
offerings reveal information about the quality of both the announcing firm’s portfolio
and the quality of rival firms’ portfolios. Therefore, the market is induced to draw
inferences about the future prospects of the entire industry.
Chaney and Philipich (2002) use an event study methodology to study 284 of the 287
Andersen clients included in the S&P 1500 to examine the stock market reaction to
various events surrounding Andersen’s Enron audit. They employ a market model to
calculate abnormal returns and examine four event windows ranging from two days to
four days. The first event window is November 8, 2001 when Enron announces
restatements. They find other clients of Andersen experience a mean cumulative
abnormal return (CAR) of þ 0.94 percent over the four-day event window surrounding
the restatement of Enron’s earnings. This suggests there was no downgrading of other
companies audited by Andersen and this was treated as an isolated event. The third
event window is January 10, 2002 when Andersen announces documents were shredded.
Contrary to the first event, they find other Andersen clients experience a statistically
negative mean CAR of 2 2.10 percent over the four-day event window surrounding
Andersen’s admission. This suggests that investors downgraded companies audited by
Andersen on the basis of a decline in the perceived quality of the Andersen audits.
Barton (2005) examined the defections of Andersen’s clients after the Enron
bankruptcy case in order to determine whether firms act upon changes in an audit firm’s
public reputation. They reviewed the defection rate of 1,229 Andersen’s clients, finding
that 95 percent of them did not switch their auditing firm until after Andersen was
indicted for criminal misconduct regarding its Enron audit. Findings further show that
the firms that left earlier were those more visible in the capital markets. These results
suggest that public firms that are visible in capital markets and are closely followed by
the press are more concerned about using a highly reputable public accounting firm.
Andersen
implosion
over Enron
681
2.2 The Big Five accounting firms
The term Big Eight originated in the 1970s when the ranking by size of US public
accounting firms showed that there was a significant difference between the top eight
and the ninth largest firm. By the late 1990s, mergers had reduced the number of such
public accounting firms to five and had increased the difference between the top five and
the firm that ranked sixth. By 2000 the Big Five firms (Andersen, Deloitte & Touche,
Ernst & Young, KPMG Peat Marwick, and PricewaterhouseCoopers) had cornered the
market on audits for most major publicly traded firms. In 2001 the Big Five audited
almost 90 percent of the Fortune 500 firms and maintained 523 global offices which
generated $63 billion of global revenues with $26 billion generated within the USA. In
2001 Andersen operated 81 offices which generated over $9 billion of global revenue, of
which over $4 billion was generated within the USA. At that time, Andersen audited 91
of the Fortune 500 firms. Upon the collapse of Andersen, the majority of their clients
were absorbed by other public accounting firms. Table I reports each Big Five’s market
shares of the Fortune 500 firms along with revenues and offices.
2.3 Event date
The first major Wall Street Journal announcement regarding the Andersen/Enron audit
scandal appeared on November 5, 2001: “Enron transaction raises new questions.”
Big Five accounting firms
1. PricewaterhouseCoopers
2. Deloitte & Touche
3. KPMG
4. Ernst & Young
5. Andersen
Other public accounting firms
Fortune 500 audits
120
83
52
101
91
53
(24%)
(17%)
(10%)
(20%)
(18%)
(11%)
Revenues ($
billions)a
US
Global
8.058
6.130
3.171
4.485
4.300
19.831
12.400
11.700
9.900
9.300
Source: aPublic Accounting Report (2001) (data for fiscal years ending in 2001)
Globala offices
151
97
111
83
81
Table I.
Big Five accounting
firms, Fortune 500 audits,
revenues, and
offices in 2001
MF
38,7
682
This announcement reported inconsistencies in the financial reports of Enron and
explained how, in order to minimize reported debt, Enron created companies which
would bring in equity and allow borrowing to occur without the debt being reflected on
Enron’s balance sheet. It was at this time that it became clear that Andersen might face
scrutiny regarding Enron’s financial reports. Later in November, Enron released its
restated financial results, lowering reported earnings for the prior four years by
$586 million. Over the following months it became clear that Andersen auditors had
failed to fulfill their responsibilities in their oversight of Enron.
Figure 1 reports the calendar dates of the seven-day event window from November
2-12, 2001. The announcement date of November 5 is labeled (event day 0), the first
trading day prior to the announcement is labeled (event day 2 1), the first trading day
following the announcement is labeled (event day þ 1), and so forth with the fifth
trading day following the announcement labeled (event day þ 5).
3. Data
To be included in the study, a firm must:
.
have been ranked as a Fortune 500 firm at least once from 1997 through 2000;
.
have been publicly traded with daily stock returns and a beta reported for the
event window on Compustat (North America) data definition; and
.
have not had a major news announcement in the Wall Street Journal within a ten
day window from 2 5 to þ 5 to avoid contaminating the daily returns in the
seven-day event window.
Three samples of firms were created and are shown in Figure 2 with the firms
identified in the Appendix. The first sample includes energy/utility firms that were
audited by a non-Andersen Big Five firm from 1997 to 2000. The second sample
includes non-energy/non-utility firms that were audited by Andersen from 1997 to
2000. The third sample includes energy/utility firms that were audited by Andersen
from 1997 to 2000. The energy/utility industry included primary SIC codes of 1311,
1389, 2911, 4911, 4922, 4923, 4931, 4932, and 5172.
4. Methodology
An event study methodology is utilized to examine the contagion effect of the Andersen
and Enron audit scandal on other Fortune 500 companies (Brown and Warner, 1985;
Figure 1.
Announcement and
event window
Figure 2.
Sample classification
Event Day
Exhibit 1. Announcement and Event Window
–1
0
+1
+2
+3
+4
+5
|————|——–|——–|———-|———-|———|
Calendar Date (2001)
11/2
11/5
11/6
11/7
Exhibit 2. Sample Classification
Andersen Audited
Energy/utility Industry
14
Non-energy/non-utility Industry
44
11/8
11/9
11/12
Other Big Five Audited
21
Peterson, 1989; Wells, 2004). The three contagion effects examined as described in
Table II.
An event study is used to measure abnormal returns in the stock prices of publicly
traded firms as a reaction to an announcement of an event. The fluctuation of stock
prices caused by an event can be isolated because of two unique characteristics of stock
prices. One, a firm’s stock price is a function of the firm’s expected future earnings.
Two, a firm’s stock price reacts to an event announcement quickly and effectively
under the efficient markets hypothesis. Therefore, any announcement of an event …
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